The Role Of Stock Rating Agencies In The Workings Of The Stock Market

Summary:Stock rating agencies are amongst the most
powerful of all firms operating in the market. They do not actually buy
and sell assets themselves, instead, they offer independent opinions as
to the value of an asset. For assets such as bonds, they provide a
'credit rating'. What all this means is explained below.

The world of Wall Street has essentially three all powerful
companies which provide credit ratings. These credit ratings are used by
investment banks, hedge funds, brokerages and so on to decide whether
an investment should be bought or sold. Clearly, this is the simplified
version, but that is the general principle.

It would be fair to say that S&P offer what is considered to
be the 'gold standard'. However, it would also be fair to comment that
all three companies tend to offer very similar ratings. This makes some
sense since they are assessing the same thing and almost certainly using
methods and calculations that are virtually identical.

Needless to say, their opinions are reported quite widely within the
financial world and therefore, their thoughts matter. Should a company
be upgraded or downgraded in their opinion, the stock price will move
very significantly to take this new information into account.

Thus, if a company is considered to be in improving financial
health, more buyers (fund managers) will become interested and demand
will rise for the stock. This will push the price higher, usually
substantially higher, quickly.

In contrast, should an agency downgrade a company due to
deteriorating financial health, there will be a rush of sellers, demand
will plummet as will the market price of the stock.

If this makes you wonder just how powerful these firms are, you
would be right to question this. Clearly, being in possession of such
information before it is released to the market could be very
profitable.

You may also have heard of stock analysts. Every investment bank and many fund managers have an army of staff that look over annual reports and the trading updates from companies (they typically focus on one sector) and then write reports on their expectations for the sector and it's constituents. As might be imagined, if a respected analyst makes a buy or sell recommendation for a sector or company it can have a profound impact on the near-term direction of the price.

The name's bond

In the bond market, the opinions of the agencies decides what
assets are applicable for funds. There are essentially just two grades
of bond - Investment grade (the best) and everything else. Everything
else is often referred to in less straightforward ways. For example,
they may be 'higher yield' because of the higher interest payments that
they must make to attract capital. Others will simply call them 'Junk'.

The agencies also assess the credit risk in investing on
government bonds. This means that they are really assessing the public
finances of governments! Such power!

As their ratings alter for currencies and bonds (they must assess
the currency a bond is denominated in to be able to assess the risk of
the actual bond), they can potentially have an impact on the financial
health of entire nations. If they downgrade a bond because of currency
instability, for example, many large investment institutions will soon
be selling their assets to protect capital. This can potentially result
in currency devaluation which has a knock-on impact to imports and
exports and the way that the country trades with the rest of the world.
This can be real world impact on a massive scale.

So for all their power and influence, just how they are regulated
and overseen is a tricky question. Their reason for existence is to
ensure that bonds are valued fairly by an independent entity. This makes
decisions for investment banks and fund managers easier to take and of
course, outsources difficult work to companies that are very able to
deal with it.

The future is not bright

However, the aftermath of the credit crisis which began in mid
2007 will almost certainly see stock rating agencies changed forever.
Many investment and pension funds around the world have purchased
mortgage products which were rated as being safe investments and have
been proved were quite clearly not suitable. Whether this is deemed to
be a fault of description, analysis or greed - only time will tell. But
AAA rated does seem to be a stretch of the imagination!

The situation was clearly very complex and your author does not pretend to understand it all, but the general issue is whether a firm that is paid to independently rate a financial instrument is really independent. If these agencies had been giving out ratings of BBB instead of AAA would they have been asked to rate as many products? There is a clear potential for a conflict of interest on their part.

At the time of writing in early 2013 there have been moves to reign in the power of the credit rating agencies by governments. The EU, for example, has riled against these firms again and again, partly because of the power they wield with their opinions on eurozone sovereign debt.

This is understandable. Having been roundly criticised for their roles in the sub-prime mortgage crisis and having not been objective enough about the role of debts on a balance sheet, they are being as objective as they can about sovereign debts. This comes at a time when politicians would like a little lee-way on the health of their national balance sheets.

For now it seems as though the EU and other governments have not figured out what to do about the situation, but it is hard to imagine that anything but firm legislation awaits this sector.

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